As the impacts of climate change intensify, businesses—particularly those in the financial sector—are increasingly aware that managing climate risks is not just an option but a necessity.
In his recent blog, Frank Elderson, Member of the Executive Board of the European Central Bank (ECB), underscored this critical point by stating, “Materiality assessments are not just a “nice to have” – knowing your risks is a precondition for being able to address them. Most banks have now drawn up materiality assessments that are in line with our supervisory expectations. This is good news, but it is only the first step. A great deal more work lies ahead. By the end of this year, we expect all banks under our supervision to be fully aligned with all our supervisory expectations on the sound management of C&E risks.”
In this blog, we’ll explore why materiality assessments are the foundation of effective climate risk management, the different approaches to materiality, and how these assessments align with regulatory requirements and business strategy.
The Importance of Materiality Assessments in Climate Risk Management
The core of climate risk management begins with identifying what is most important to a business—what risks are “material.” Materiality assessments is the process of identifying and prioritizing the environmental, social, and governance (ESG) risks that significantly affect a company’s operations, products, and services, as well as the broader ecosystems in which it operates. Materiality assessments provide a structured approach for businesses to recognize which issues are most relevant to their long-term success, especially when it comes to sustainability and climate risks.
According to Elderson, materiality assessments are no longer a “nice to have” feature but are prerequisites for banks to effectively manage climate and environmental risks. He emphasizes that climate risks are not just standalone concerns but drivers of traditional financial risks, such as credit risk, market risk, and liquidity risk. Consequently, neglecting climate-related risks is akin to ignoring any other critical risk category, which is why materiality assessments play a foundational role.
Single, Double, and Triple Materiality Assessments: A Framework for Understanding Climate Risks
Materiality can be assessed at different levels, depending on the scope and complexity of the risks. These levels are typically categorized as single, double, and triple materiality, with each offering a broader understanding of how climate risks interact with an organization’s operations and external environment.
- Single Materiality focuses primarily on how external risks, including ESG risks, impact a company’s financial performance. This inward-looking perspective is often the starting point for businesses assessing their exposure to climate risks.
- Double Materiality takes a more comprehensive approach by looking both inward and outward. Not only does it assess how climate risks impact the company, but it also considers how the company’s operations affect the broader environment. This is especially important in the context of climate change, as businesses both contribute to and are affected by the environmental crises.
- Triple Materiality further broadens this view by incorporating ecological, social, and economic contexts. It addresses local and global value chains and accounts for more complex interactions between a business, its environment, and its stakeholders. While this approach is less common, it is growing in importance as climate-related risks become more pronounced.
By engaging in materiality assessments at these different levels, companies can prioritize their risks and resources more effectively. Elderson notes that most European banks have adopted double materiality, particularly under the guidance of the ECB’s 2020 expectations for integrating climate risks into governance and strategy.
Stakeholder Engagement: A Critical Step in the Materiality Assessments Process
Materiality assessments are not conducted in isolation. A critical component of this process is stakeholder engagement, which involves consulting both internal and external parties who have a vested interest in the company’s operations. These stakeholders can include employees, investors, supply chain partners, local communities, and customers, all of whom provide valuable insights into what is considered material from various perspectives.
Elderson emphasizes the role of this engagement in providing a more rounded view of risks, controls, and processes, ensuring that blind spots are minimized. For example, while employees may be concerned about workplace health and safety, investors may prioritize financial stability, and customers may focus on product sustainability. By integrating these different viewpoints, businesses can develop a comprehensive understanding of the material risks they face.
This stakeholder-driven approach also enhances accountability and transparency, key factors in building trust between companies and their stakeholders. Many organizations now include stakeholder engagement as part of their ESG reporting, highlighting how the process shapes their materiality assessments.
Regulatory Alignment: Navigating Compliance Through Materiality
Governments and regulators are increasingly focused on climate risk disclosures, and materiality assessments have become an integral part of compliance. For example, the Corporate Sustainability Reporting Directive (CSRD) in the European Union mandates double materiality assessments for climate-related risks. Similarly, the Securities and Exchange Commission (SEC) in the United States has implemented rules that require companies to disclose climate risks, aligning with financial materiality standards.
The ECB itself has established a series of deadlines for banks to meet its supervisory expectations regarding climate and environmental risk management. By the end of 2024, all banks under ECB supervision are expected to have fully integrated materiality assessments into their governance and risk management frameworks.
Elderson notes that while significant progress has been made, more work remains. The ECB has not hesitated to impose penalties on banks that fail to comply with these deadlines, emphasizing that materiality assessments are fundamental to sound risk management. In 2023, for instance, the ECB issued binding decisions for 23 supervised entities and penalized 18 banks for failing to meet the March 2023 deadline for submitting adequate materiality assessments.
ESG Reporting and Frameworks: Building on Materiality Assessments
Materiality assessments are often guided by established ESG reporting standards and frameworks, such as the Taskforce on Climate-related Financial Disclosures (TCFD), Global Reporting Initiative (GRI), and Sustainability Accounting Standards Board (SASB). These frameworks help companies categorize and report on their climate-related risks, providing a structured approach to materiality assessments.
The TCFD and SASB standards, for example, focus on financial materiality, helping businesses identify how climate risks impact their financial performance. In contrast, GRI emphasizes impact materiality, looking at how businesses affect the environment and society at large.
Adopting these standards not only helps companies comply with regulatory requirements but also ensures consistency and comparability in climate risk disclosures, which is crucial for stakeholders who rely on this information for decision-making.
Continuous Improvement: Materiality is Not One-and-Done
A key takeaway from Elderson’s remarks is that materiality assessments should not be seen as a one-time exercise. As business environments and climate risks evolve, companies must regularly reassess their material issues. Elderson recommends annual reviews of materiality assessments to ensure they remain aligned with the latest risks and opportunities.
This continuous improvement approach ensures that businesses remain resilient in the face of changing climate conditions and evolving stakeholder expectations. By keeping materiality assessments up to date, companies can more effectively integrate climate risks into their broader strategies, fostering long-term sustainability.
Materiality as the Cornerstone of Climate Risk Management
As climate change continues to reshape business landscapes, materiality assessments have become indispensable in managing climate risks. From stakeholder engagement to regulatory compliance, these assessments provide the foundation for identifying and prioritizing the most significant risks and opportunities. By making materiality assessments a core component of their climate risk management strategies, companies—especially in the banking sector—can enhance their resilience and position themselves for long-term success in a low-carbon economy.
